Business Models

The next dimension you should be aware of is business models. Quite simply, this answers the questions: “who pays?”, “what directly makes revenue go up?”, and (not often enough) “what must the company spend money on?”

The most common ones you should be aware of are:

Most other companies that employ software engineers have aspects of these embedded within them. I cannot do justice to them in the space I have here, but I will at least introduce them and try to give you enough to learn more.

Agencies#

The agency model is the most common model for small teams. I don’t have numbers for this, but my guess is it is responsible for most tech jobs as well.

• With an agency model, you have one or more clients, and you are paid for your time.
• If you are a dev team within a bigger, non-tech company, you are basically an in-house agency with one client.
• If you are a consultant or freelancer, you are a one-person agency.
• There are a thousand small ways to tweak dev setups and payment terms, but broadly, as the amount of dev-hours grows, so does the amount of money flowing into the agency.

Ideally, you should be trying to get the most done per hour, but cynically, bad incentive systems can lead to just booking more hours. The common thread is that your income isn’t fully pinned to the success of your client’s business, which is sometimes a feature and often a bug of the Principal-Agent Problem. Despite the flaws, agencies are still so popular because of the sheer amount of work that needs to be done and the specialized talent needed for certain types of high-skill work.

Advertising#

The advertising (or Media) model is next most common. Here, you make money by increasing the traffic to your site or usage of your product and then selling advertiser spots.

• Sometimes, the advertising is display ads (paying for cost per miles - aka ears and eyeballs - just to be present and build brand awareness).
• Most advertisers these days prefer _ performance-based_ marketing - paying for directly measurable user actions, e.g., cost per click.

Most social networks and news/opinion sites run this way, though there is massive assortment of marketing technology to help ad buyers find the best ad inventory. Because end users pay nothing and advertisers pay for access, the derisive view is that “users are the product.” However, this may not always be negative; the Wirecutter and the Points Guy are both well-regarded high-quality content sites that make their money from affiliate marketing, which is a variant of performance-based marketing (pay-on-purchase rather than pay-per-click).

Social media vs. digital media#

Social media and digital media differ in one important way. Digital media companies have to hire journalists and editors to create content that draws people, whereas social media companies get user-generated content for free.

Social media#

Social media is a unique intersection of tech and society, where we trade our information and attention for news and social status. On paper, you might be an ads business, but as far as humans are concerned, you offer Status as a Service. People literally compete to give you their best content for free. This sounds like a wildly attractive proposition, and at first, it was. You can see Reid Hoffman’s Series B pitch deck for LinkedIn to appreciate just how compelling it is.

However, in recent years, the hidden “cost” of running a social media company has emerged in need of content moderation. You might start as a technologist and end up spending all your time debating the fine points of 47 U.S.C. § 230 and de-platforming and misinformation.

Digital media#

With digital media companies, including podcasts, the trend has been toward realizing that ads aren’t the only way to make money; you can charge your audience directly! That leads us to subscriptions.

Tip: The reality of most media companies today is to tend toward some sort of hybrid advertising (for free users) and subscription model (for highly engaged users), so it isn’t an either-or proposition.

Subscription#

The next most common type of business model is subscriptions.

• If you sell usage of your software, this is known as Software as a Service (SaaS), which is an investment category all its own. The common characteristic of the IaaS/PaaS/SaaS models is they transform fixed cost to variable cost, which provides immediate value for customers.
• Content subscriptions are the other major category. This includes audio (Spotify), video (Netflix), news (the New York Times), blogging (Stratechery), data (Crunchbase), or membership to a professional group/community. All of which require software to support them.

The gross margin is high#

Since users pay directly for the software/content/membership and can walk away at any time, the incentive alignment is clear: use subscription revenue to make a better offering, which helps drive more subscriptions, helps finance a better offering, and so on. Since digital content can be replicated infinitely, the gross margin and, therefore, cash flow of these kinds of businesses is high. To grow, the business has to expand its marketing funnel, increase conversion rates, keep a lid on the cost of content (e.g., revenue sharing with content creators), and decrease churn.

Subscription businesses are a buffet#

Most subscription businesses are a buffet- pay your subscription, and it’s all-you-can-eat. This has an inherent flaw; some people just eat a whole lot more than most. This is expensive to support, and the lighter users subsidize those who “abuse” the platform (by bringing down average usage). Therefore all subscription businesses eventually start charging per seat and find their way toward some form of metered billing (using some form of value metrics). Doing this too eagerly can have the perverse effect of punishing your most engaged users.

Fun fact: Marc Benioff is widely credited with inventing SaaS and ironically introduced it with the famous “No Software” campaign in 1999.

Marketplaces#

Marketplaces are the hardest software businesses to build, and therefore there are fewer of them than other kinds of businesses. However, once established, they exhibit gobsmacking double-sided network effects, which makes them very valuable (Bill Gurley describes marketplaces as creating “money out of nowhere”). Developers both use and work for marketplaces every day without realizing it; these range from Airbnb and Uber to Cameo and Udemy (see this list for more).

Marketplaces match buyer and seller, just like their offline counterparts. The marketplace assures both sides of:

• Liquidity: buyers will be able to find what they want, sellers will be able to sell what they have, and both can do it faster than anywhere else
• Quality: buyers are good customers whose checks don’t bounce, and sellers must not sell fake or defective products, or they get kicked off the platform.

Buyer or seller pays money#

In exchange, it takes a fee from either the buyer, seller, or both. The fee typically is a percentage of the money that changes hands. This is called a take rate, and marketplaces want to grow the gross merchandise volume it is based on. Take rates range wildly based on platform power. For example, Gumroad charges 3.5% while Apple and Google’s app stores take 30%.

Additional ways to make money#

This model sounds simple, but there are a lot of ways to make additional revenue. For example, suppliers often pay certification or listing fees, or they could instead be paid to join. It also turns out that a marketplace’s site is prime ad space and that customers will pay for better service. So, as your marketplace progresses, the Hierarchy of Marketplaces, you can build both an entire advertising business AND an entire subscription business INSIDE a marketplace business, which is what Amazon has done.

In a way, this is the business model to end all business models because you essentially now run your own economy.

Most platforms eventually add marketplaces, sometimes called App Stores.

Fun fact: Steve Jobs gave Marc Benioff the idea for Salesforce AppExchange, the first “App Store” in 2005.

Advantages#

Here are two final major advantages you need to know:

• Marketplaces don’t own inventory since suppliers are the ones to bring their inventory to market. This makes them asset-light, which means they can scale enormously with little investment. Airbnb offers more room nights than any hotel chain in the world, without owning any hotels. Uber and Lyft transport more passengers than any taxi company without owning a car.
• Large enough marketplaces drive both seller and buyer to optimize for each other. Buyers want high ratings (especially when buying repeat services), and sellers want great reviews. The slightest nuances of the platform- everything from picture dimensions to product offered- will be exploited to exactly meet the marketplace’s needs. This not only means that buyers and sellers are optimizing for each other for free, but it also makes starting a competitor marketplace extremely difficult since investments have been made and reputations gained. In other words, great marketplaces have positive virtuous cycles.

Marketplaces are hard to build#

These benefits aren’t free; marketplaces are hard to build for a few reasons:

• Fakes and disputes: Marketplaces offer an implicit or explicit guarantee of quality, which means they need a way to handle what happens when things go wrong.

• If goods are sold, you must handle the issue of fakes, lemons, and returns. This might not seem fun, but Zappos made a great return policy a competitive advantage.

• If services are sold, you must handle a billion things that can go wrong when humans work for humans, and you’re not around to verify what actually happened. Airbnb had to roll out a million-dollar liability insurance program to reassure hosts, whereas Uber uses its rating system to keep drivers in line.

• The art of maintaining marketplace quality is an entire discipline of its own. Underlying the entire discussion is the fundamental problem of how to create trust between strangers. The best place to learn more is through Lenny Rachitsky’s research.

• Cutting out the middleman: Every strong supplier eventually chafes at paying the take rate. At stake is not only more revenue but also a more direct, long-term relationship with the customer, free of any unfavorable changes the marketplace may make in the future. For service marketplaces, buyers and sellers who like each other enough can simply take their relationship “offline”. This means that buyer and seller churn (also known as platform leakage) is a huge problem for marketplaces, and it must provide a compelling reason for both sides to stay on even after they have found each other. The two natural reasons to stay are opposites: either infrequent, large transactions where reputation matters (Airbnb) or frequent, small ones where you don’t care who does it in the form of perfect competition (Uber).

• The chicken-and-egg issue (alternatively, the “cold start” problem): If there aren’t enough buyers, it is not compelling for suppliers to join the platform. If there aren’t enough suppliers, buyers won’t even come by. A marketplace can toggle back and forth between being demand or supply constrained a few times in its life. As many as 40% of marketplaces remain supply-constrained throughout their entire life, which is why having an encyclopedia of ways to grow marketplace supply is a hot topic.

• Political risk: Successful marketplaces are very disruptive to the livelihoods of many legacy sellers because they commoditize their offerings. There is almost always political backlash because of the tremendous power shift. If lobbying is successful, your marketplace could be destroyed by legislative fiat.

Be your own supplier#

One way to get past many of these issues is to be your own supplier, so you only grow the demand side of the market. This is sometimes called “single-player mode”. If your “marketplace” has value without any network effects, then it has a reasonably good chance of attracting enough people to get network effects (often referred to as “come for the tool, stay for the network”). You could view all eCommerce businesses as “one-sided marketplaces”, although the trendy term for this is Direct to Consumer or “D2C”.

Gaming#

In reviewing this section, Julian Garamendy pointed out one other business model that wasn’t quite accounted for: Gaming. Given that gaming is a huge megatrend, I feel I must address it somewhat. Some games, like World of Warcraft, are subscription businesses. Other console and PC games like Zelda and Red Dead Redemption are one-off purchases, akin to D2C eCommerce with entirely virtual goods.

However, there is a massive genre of games that consists of microtransactions and real-money auction houses, including games like Fortnite, Candy Crush, Star Wars Battlefront, and Diablo 3. These rely on “whales” getting hooked and are more akin to casinos. They may not be the most beneficial software humanity makes, but they generate enough money that they must be acknowledged.